Employee Ownership in the Private Organization

By Marc S. Stander. For master's thesis at University of Denver, March, 2003 - shared with Corey Rosen of NCEO.

Marc Stander is the Web Applications manager and IT Employee Ownership liaison to the Stock Administration group at CH2M HILL, an employee owned company in Englewood, Colorado. Marc can be reached at marc.stander@ch2m.com.

Abstract

Employee stock ownership plans (ESOPs) provide an excellent exit strategy for business owners while offering part or all of the company to the employees. Research shows that employee ownership alone will not increase company performance. Creating the ownership culture is very important if the employee ownership program is expected to increase profits, sales, and stock price. Employees need to be involved in workplace decisions and must act like owners or the full benefits of an ownership program will never materialize. When the corporate culture and ownership program are aligned, the employee ownership program will more likely be successful.

Introduction

Statement of the Problem

Louis Kelso, a lawyer and investment banker, developed the employee stock ownership plan (ESOP) concept in the 1950s. Mr. Kelso argued that capitalism would thrive if all workers, not just a few shareholders, could share in owning capital-producing assets. Since there was no clear legislation at the time on how to implement an ESOP, few were created. In the early 1970s, Kelso convinced Senator Russell Long, who was the chairman of the Senate Finance Committee, that tax benefits for ESOPs should be enacted under employee benefit law. In 1974, Employee Retirement Income Security Act (ERISA) was passed. “ERISA was enacted to ensure that employees receive the pension and other benefits promised by their employers,” (Benefitsnext, 2002). ERISA also formed a statutory framework for ESOPs. ERISA allows company owners to take a tax break for sharing ownership with the company’s employees (NCEO, 2002).

ESOPs have been providing corporate tax benefits since 1974 but many tax professionals are not aware of the benefits that employee ownership can provide. Owners of businesses can sell part or all of the company and defer the taxes on the capital gains. Also, the company then can contribute tax-deductible shares of stock to employees. Studies also show that when employee ownership is combined with a participative management style, company performance is greater than non-employee owned companies. “During the early 1980s, the National Center for Employee Ownership conducted an exhaustive investigation of how employees react to being owners. The conclusion was clear: The monetary incentives provided by an ESOP are certainly compelling, but without a genuine and effective ongoing program to involve the employees in workplace decisions, the most important benefits of an ESOP will never materialize. The employees need to feel like owners. And when they do, they will respond with increased productivity, greater loyalty, and sustained creativity,” (Girard, 2002). There is an inherent problem with ESOPs. In an ESOP, in most circumstances, for the employee to reap any of the rewards, he or she must terminate, retire, or die. ESOPs in their pure form do not allow shareholders to cash out whenever they wish. Creating liquidity in the employee owned company is an important incentive that companies should consider.

Many private business owners get pressured to sell their companies to larger public or private companies. An ESOP provides an alternative to selling the company and risking layoffs or relocation of the employees. For example, assume a private company owner wants to sell his or her company and the company is worth one million dollars. The owner can sell any or all of his or her stake in the company to the company ESOP. If the company has funds available and purchases the owner’s interest outright, the ESOP is considered a non-leveraged ESOP. The shares purchased from the owner are put in the ESOP and the shares are filtered into employee accounts in form of cash or stock based on a predetermined formula. In the case of a leveraged ESOP, the company borrows the capital from a bank or other lender and puts the borrowed money in the ESOP. The borrowed money is used to purchase the owner’s interests in the company. The payment to employee accounts is the same as a non-leveraged ESOP, but the payments occur when interest and principal payments are made back to the bank from the company for the borrowed funds. In the case of an ESOP, the employees get a piece of the company, and the original owner gets to sell the company if he or she wishes. On top of the above benefits listed, the seller does not have to pay any capital gains on a sale to an ESOP. “There are certain requirements that must be met in order to be eligible for this ’tax-free rollover,’ key among them being that: 1) the ESOP must, at the conclusion of the sale, own at least 30 percent of the company; and 2) the seller must reinvest his sales proceeds in ’qualified replacement property‘ (basically, any stocks or bonds of American companies) within 12 months of the sale,” (FED, 2003).At a 30% tax rate, the business owner saves $300,000 selling to an ESOP vs. selling the company outright. Along with the monetary savings, the employees now own the company and are in charge of their own destiny.

A unique situation exists for privately held companies that issue stock. Unless there is a market to buy and sell the stock, the stock may be viewed as useless unless an internal trading market is put in place for the private company to create liquidity for the shareholders. A private market allows employee shareholders to buy and sell stock of the private company. Unlike public companies, private companies cannot go to a public exchange to see at what price the stock is trading. Valuations of the company should occur regularly and a formula needs to be created to price the stock of a private company. For employee owned companies that have an ESOP, yearly valuations are mandatory (FED, 2002). Several approaches to company valuation can be used, including asset approach, market approach, and income approach (Fowler, 1997). “ERISA stipulates that an ESOP must not pay more than adequate consideration for the security. Absent a nationally recognized exchange, closely held stock, in general, requires an independent appraisal by a qualified financial advisor,” (FED, 2002).

An employee owned company consists of individual employees who are owners and have a common goal. When employees are owners, they will be motivated to work harder to increase revenues and reduce overhead costs. A study of employee owned companies showed that 75% experienced increases in profits, sales, and stock price after employees became owners. Approximately one half of the companies saw an increase in customer satisfaction. Studies also show that employees produce less when absentee investors reap the rewards of their labor (Duncan, 2001). On the surface, it appears that there are definite benefits to employee ownership. Employee ownership motivates employees to strive for corporate goals and allows employees to share in the rewards of the successful company.

Goals and Objectives

Employee owned and non-employee owned companies can benefit from this project, as it helps address the following issues:

  • Considerations for companies to determine whether to become employee owned or not.

  • Determining if employee owned companies perform better than non-employee owned companies.

  • Creation and fostering of an ownership culture.

  • Determining if employee ownership increases corporate productivity.

  • Benefits of liquidity in a private employee owned corporation.

This project can be a starting point for a non-employee owned company that is considering creating an employee ownership program. This project will outline perspectives on whether to create an employee owned company. An overview of different types of ESOPs will be discussed along with different methods to distribute equity among employees.

Creating employee ownership is not appropriate for all companies, and is a large task. Many aspects of employee ownership will be discussed in this paper.

Does creating employee ownership really empower employees to share information and act like owners? Is it the ownership that creates the culture, or is the culture another aspect that the company must consider when deciding whether or not to become employee owned?

What is the point of employee ownership if the employees have no liquidity for their investments? An analysis and review of private companies that provide liquidity for employees will occur.

Benefits

This project will review employee ownership and what benefits, if any, employee ownership provides the company and employees. The corporate culture aspect will be discussed. How is corporate culture created? What kind of culture needs to be created for an employee owned company to thrive and survive? Can anything be learned from employee ownership programs that have failed?

This project will incorporate disciplines that are taught in the Technology Management program at the University of Denver’s University College. This project will apply what is taught in the classroom to analyze a system, and suggest improvements or best practices to that system.

Literature Review

"Employee ownership refers to ownership of a business by its employees, generally (in the U.S.) through stock ownership of a corporation through an employee benefit plan. More specifically, ownership that is broad-based--that is, distributed among most or all of the employees, so that the company has a work force of employee-owners,” (NCEO, 2002). A true employee owned company does not discriminate who can own shares and who cannot. When directors and above or some other segment of a company are allowed to own shares, but others are not, a true employee owned company does not exist. This would be “key employee ownership”, not employee ownership.

ESOPs are governed by the ERISA (Employee Retirement Income Security Act), which was created in 1974. Since 1974, many changes to this act have transpired, most dealing with tax implications. ESOP companies must appoint a trustee to act as the plan fiduciary. Most small companies appoint a person or have an ESOP committee, while many larger companies appoint this function to an outside institution (NCEO, 2002).

Below are ESOP facts and figures as listed by the ESOP Association (2003):

ESOP Facts and Figures

Approximately 10,000 ESOPs in the US.

Approximately 8 million employees participate in ESOPs (8% of private workforce).

Only about 1,000 ESOP companies are public covering 4,000,000 employees.

Approximately 2,500 ESOP companies are majority-owned by the ESOP.

Approximately 1,000 companies are 100% owned by the ESOP.

Approximately 4% of ESOP companies are unionized.

More than 25% of ESOP companies are in the manufacturing sector.

At least 75% of ESOP companies are or were leveraged, which means they borrowed funds to acquire securities held by the ESOP trustee.

A total of $20 billion in cash and stock was contributed to ESOPs in 2000.

Figure 1. Facts and figures for ESOPs according to ESOP Association, (2003).

There are approximately 10,000 ESOPs in existence today. “The number of ESOPs is growing while the number of participants is shrinking because the average size of companies with ESOPs has been shrinking. Thus, on the one hand there are more plans, but on the other hand they are in companies with fewer employees,” (NCEO, 2002).

There are two types of ESOPs that a corporation can set up: Non-leveraged and leveraged. A leveraged ESOP is where the corporation borrows money from an outside source, typically a bank, and then loans the funds to the ESOP. The money that is loaned to the ESOP account is used to purchase stock and the stock is held in suspense. The stock is then released to employee accounts as the loan is repaid. The release of stock to the employee accounts is based on a pre-determined formula, usually based on salary (FED, 1998).

Two tax incentives make borrowing through an ESOP extremely attractive to companies which might otherwise never consider financing their employees’ acquisition of stock. First, since ESOP contributions are tax deductible, a corporation which repays an ESOP loan in effect gets to deduct principal as well as interest from taxes. This can cut the cost of financing to the company significantly, by reducing the number of pre-tax dollars needed to repay the principal by as much as 34%, depending on the company's tax bracket. Second, dividends paid on ESOP stock passed through to employees or used to repay the ESOP loan are tax deductible. This provision of federal tax law may increase the amount of cash available to a company compared to one utilizing conventional financing (ESOP ASSN, 2003).

The employee usually receives payout of the ESOP account upon termination or retirement (FED, 1998).

A non-leveraged ESOP is where the corporation makes stock or cash contributions to the ESOP trust account on behalf of the employees. Company contributions are then allocated to employee accounts based on a pre-determined formula, typically a percentage of the employee salary. The employee usually receives payout of the ESOP account upon termination or retirement. The corporation may deduct the value of the contribution based on IRS limitations (FED, 1998).

ESOPs can be complicated and expensive to set up. Set up fees can vary, and in most cases, a minimum of $20,000 must be spent to implement an ESOP, and maintenance fees may cost several thousand dollars per year (NCEO, 2002). Setting up a leveraged ESOP is usually more expensive than setting up a non-leveraged ESOP. A 1%-3% loan origination fee will apply for a leveraged ESOP since borrowing funds is necessary, which could add thousands of dollars to the implementation (NCEO, 2002). The expected tax savings and increased productivity should offset the costs of implementing the ESOP in just a few years.

Laws dictate that non-public companies with an ESOP must have an outside valuation process intact. This law prevents the ESOP from paying too much for shares. While the shareholders selling to the ESOP may benefit by overpriced shares, this can cause companies to have financial difficulties. If employees feel that the shares are overpriced, and there is no independent valuation process, the employees may lose faith in the ESOP program. Laws dictate that valuations must be made at least annually. Other circumstances may require valuations at a more regular period (Rodrick, 2000).

There are three valuation approaches that appraisers normally use when performing a valuation on a company: asset approach, market approach, and income approach. An asset approach sums up all tangible and intangible assets of the company to determine a fair market value. A market approach evaluates the market that the company is involved in, and compares itself to other similar companies in the market. Based on values of the competitive companies, the appraiser tries to derive a value for the company that is being appraised. Lastly, an income approach tries to derive the value of all future benefits that the company will gain from present investments (Fowler, 1997). The valuation process ensures the price that employees and the company pay for shares is fair. This prevents a company from being overvalued based on outside interests.

Motivation theorists suggest that one of the most effective ways to motivate employees and managers is to allow everyone to become an owner of the corporation. For years, stock options have been used to motivate managers and retain executives. Ownership should also be used to motivate employees at every level (Shanney-Saborsky, 2000). The following are incentives of employee stock ownership in the corporation as listed by J.W. Duncan (2000):

Ownership adds the promise of extraordinary personal wealth creation to otherwise modest compensation programs. The data are clear--routine salary increases alone will not significantly increase the real earnings of rank-and-file employees. During one of the longest periods of prosperity in our recent history, workers have averaged only about three percent per year increases in pay. Incentive stock options that merely reflected broad stock averages could have netted 20% or more in the late 1990's. Ownership effectively reduces the perceived inequity problem.

Ownership makes it attractive for talented and mobile employees to stay with the company rather than bouncing from one job to another for higher base pay. As retirement funds become more portable, vesting schedules will become increasingly important as a means of retaining valuable employees and executives. The agency problem is reduced.

Ownership works only when employees understand the risks. Communication of the risks should be a part of any stock option program. Performance targets may not be met; if not, the extra earnings will not be forthcoming. Industry factors may affect the market so that even if performance targets are attained or exceeded, the options may have little or no value when they vest. Issues relating to perceived inequity may be increased unless employees understand the risks as well as the rewards of ownership. Moreover, stock options create unique, complex, and frequently adverse tax affects. Companies should at the very least alert recipients to obtain competent tax advice on how to account for the value of the options received.

When all employees are rewarded for their hard work through an ownership program, both the employees and company thrive.

A company can use various methods to distribute equity to its employees. Many of the more popular methods include direct and payroll stock purchase plans, stock bonus awards, stock options and 401ks. There are benefits and drawbacks to each of these distribution methods.

Stock purchase plans allow for employees to participate in short and long term company growth. Direct purchase plans can be targeted to certain employees in the company and can be discounted. When direct purchase stock is discounted, the recipient is taxed on the discount and the company gets to write off the discount as a deduction. Direct stock purchase plans can be tailored to meet specific company needs, such as reducing a tax burden (FED, 1998).

Payroll Deduction stock purchase plans (PDSPPs), or Section 423 discount purchase plans, are much different than direct stock purchase plans. PDSPPs must be offered to virtually all employees, price must be based on fair market value, proceeds are withheld from payroll, a discount limited to 15% may be offered, the discount is not taxable to the recipient and the company cannot write off discounts as a deduction. Payroll stock purchase plans can only be offered to current active employees but employees with greater than 5% of company stock must be excluded from participation (FED, 1998). Since employees voluntarily purchase a stake in the company with their own money, employees may feel more accountable for their actions and company performance. For example, if an employee has invested $10,000 dollars in a purchase plan, that employee might be more concerned with the spending habits of the company. Reducing costs or increasing revenues might be more important to an employee who has invested his or her after tax income in the company. Stock purchase plans can provide short, mid, and long-term benefits to the employee if the company meets financial goals and the value of the stock increases.

There are two types of stock bonus awards: restricted and non-restrictive. Restricted bonuses may require an employee to spend a certain amount of time with the company or require certain performance goals be met before the shares become un-restricted. Non-restrictive bonuses are a direct award of stock. Stock bonus programs are simple, flexible, easy to understand, and can be tailored to meet specific corporate goals (FED, 1998). One disadvantage of bonuses is since the employee was given a bonus and did not have to invest his or her money, that employee might not have the same appreciation for the shares or piece of ownership.

Stock options are typically seen as favorable from both the company and employee perspective. Stock options give an employee a vested interest in the company and provide performance incentives while allowing the company to preserve capital, recruit and retain employees, and align corporate objectives. Stock options give an employee the right to purchase shares of the company within certain dates at a fixed price, usually determined by formula or price of shares when the options were granted. Employees are not bound to purchase the shares, therefore there is no risk to the employee if he or she decides not to exercise the options or the share price goes down. If the share price goes up, the employee has the right to purchase the stock at the previously determined discounted price (FED 1998). Stock options directly link company performance and employee rewards, through increased share price. Although stock options can be somewhat more confusing than other types of equity sharing, employees understand that company performance and increased share price will benefit them in the long run when the options vest. Some important benefits of stock options are listed below as documented by J.W. Duncan (2000):

Owners are more committed to the success of the enterprise because business success is transferred directly into personal wealth. If the company's stock goes up above the option price, financial gain results from exercised options. Stock price is related to earnings, financial performance, and a number of other factors that employees can directly influence.

Owners are committed to improving the business in every way possible, because in doing so they reap the financial rewards associated with improved performance.

Ownership opportunities assist in recruiting and retaining the best candidates in the labor market. Enterprising employees who receive stock options are allowed to participate in the success of the organization. Leaving the firm before vesting results in forfeiture of a potentially significant amount of personal wealth. At a time when the unemployment rate has dropped below four percentage, and the labor market for skilled and experienced employees is as tight as anyone can remember, making employees owners is a valuable recruitment and retention tool. Stock options, project completion bonuses, and other forms of gain sharing are the common currency in the Silicon Valley and are spreading to all areas of the economy. The value of stock options often amounts to several times a rank-and-file employee's annual salary.

Corporations can offer significant value to employees through stock options and receive extremely favorable treatment from the Internal Revenue Service. Stock options do not cost the company anything (except dilution of ownership when exercised) because they have no cash value. Moreover, when the options are exercised the tax code allows companies to deduct the gain as an expense even though no money has been spent. Employers can give increases in pay that do not cost them anything.

Stock options can be an effective way to motivate current employees and recruit future employees, at low cost to the employer. There is pending legislation to determine if employers should expense stock options. If this legislation is passed, companies may not favor options as a method to distribute equity as much as they do now.

A 401k plan allows employees to use tax-deferred funds to invest for retirement. When a company matches or allows employees to invest in company stock, the employees can build equity in the company. The company may contribute a percentage of the employee contribution, or may decide to give lump sum amounts based on profitability or another factor independent of what the employee contributes. A 401k is an easy way for many employees to participate in employee ownership on a pre-tax basis. The company can write off contributions and when the company contributes stock to an employee 401k plan, and the company is preserving capital (FED, 1998). Employees should make sure to diversify their retirement plans. The recent news of ENRON and Worldcom reinforces the principles of diversification. A 401k provides a long-term approach of building wealth. When the employee owned company invests in its employee’s futures, the employee might be inclined to be more motivated. Increases in share price will mean more money at retirement for the employee. The employee may invest his or her pretax investments in company stock, increasing interest in long-term company growth.

It is logical to think that employees who own shares in a company will be motivated and act like owners of the company. “Research completed during the last 10 years consistently indicates that employee ownership alone is not likely to have an impact on standard available measures of company performance such as sales growth, growth in the number of employees, or operating cash flow performance. On the other hand, researchers have found that companies that combine employee ownership with participation perform better than they did before implementing an ESOP and perform better than similar companies that are not employee owned,” (Rodrick, 2000). There may be many cultural contradictions when implementing an ESOP in a company that traditionally does not show mutual respect for management and employees, does not communicate freely, or where employees do not share responsibility for their actions. Management needs to think about these considerations just as much as the financial benefits an ESOP provides, before implementing an ESOP.

A study performed by Professor Hamid Mehran from the Kellogg Graduate School of Management looked at the qualitative and quantitative aspects of employee ownership. The quantitative study looked at financial performance of 382 companies for two years before and four years after implementing an ESOP. 79% of the companies survived the full six years of the study. The study determined:

  • Return on assets (ROA) was 2.7% higher for the 382 companies than their peers without ESOPs for each year in the four-year period. For the “survivors,” the return was 14% greater than the industry average each year after the four years.

  • Total shareholder return (TSR) in ESOP companies was cumulatively 6.9% higher over the four years than their industry counterparts. For the 303 surviving companies, cumulative four-year TSR was 12% greater.

The results for ESOP companies seem very positive. “Employee-owners see things differently, they take appropriate risks, they do what it takes to make the business grow, they are not satisfied with being average,” (Godfrey, 2000).

Design and Implementation of the Project

Culture

Employee ownership alone is not enough to create a true employee owned company. Just as important is creating a culture where all employees act like owners and share responsibility for corporate results.

South Bend Lathe was the first 100% employee owned company that funded an ESOP with 100% capital credit. South Bend Lathe was started in 1906 and acquired by a large conglomerate in the 1960s, Amsted Industries. In 1975, Amsted Industries decided to liquidate South Bend Lathe, which would threaten 500 jobs. South Bend Lathe borrowed $9.2 million in a few months to save the company through an ESOP buyout. South Bend Lathe’s ESOP gave all voting rights to management, and none to the union workers. The United Steelworkers union agreed to this and did not assist its members in negotiating any ownership issues. South Bend Lathe’s union workers went on strike in 1980 for a cost of living increase. As the strike continued, it was determined that the union workers were striking because they found out that they had no voting power as shareholders, and they felt that management refused to be held accountable for the employee owners. When the management stated that the rules revolving around voting rights could be amended, the union stated the voting rights were not an issue for collective bargaining (Kurland, n.d.).

South Bend Lathe’s ESOP program generated new expectations and created problems for management, employees, and the labor union. South Bend Lathe needed to change the mentality of the old wage system and false job security to a culture that shared risks, responsibilities, and rewards of employee ownership. South Bend Lathe learned that employee owners wanted to share voting rights, and when this did not happen, the employees did not really feel that they shared in the future success of the company (Kurland, n.d.). What the labor union employees did not realize is that they were striking against themselves. They were employee owners, but they did not feel like owners. The members of the labor union actually wanted voting rights. This would have given these workers a sense of contribution to the company’s future. The management stated that voting rights could be included in the ownership plan. The labor union failed to see this and did not want to discuss employee ownership with South Bend Lathe’s management. When a positive employee ownership culture does not exist within an employee owned company, and employees do not see themselves as owners, an ESOP may be destined to fail before it even gets off the ground.

Creating an ownership culture should be as much of a consideration for a company as how to create the employee ownership program. Actually, creating the culture should be part of the employee ownership program. Many times, companies think that if employee ownership is created, the culture will follow. The culture needs to be created around the company’s long-term goals. Employees need to be trained on how to act like owners, and management needs to use an open book management approach.

Companies need to share bad news, as well as good news, with employees. In the traditional environment, management does not share bad news because they think poor company performance pushes employees to look for another job (Ivancic, 1999). In an employee owned company, employees are seen as owners, therefore should share good news as well as bad news. When sharing bad financial news, the whole company should identify what went wrong, and what should be done differently to get back on track. Employees should be allowed to communicate about negative performance, as well as positive performance. When performance goals are not met, an analysis needs to be conducted to determine why not, and a strategy developed to get back on plan. If plans are not met because employees aren’t trained in a certain area, they need to be trained. If plans were not met because of a lack of sales, employees need to find out why and come up with a plan to get back on schedule. When negative results are communicated to each employee in the company, the employee owners will act in a way that will eliminate the problems, if the problems have been properly identified. When negative results are shared throughout the company, trust is built. Employees will see that management is not hiding information from them, and employees will feel more secure in sharing information with management.

Companies need to share all financial information with their employees. People make informed decisions when they have correct and timely information upon which to base their decisions. This is the key to open book management. Employees need to be trained on how to read financial statements and what they mean. Each employee should realize what he or she really means to the company at the macro level (Stack & Burlingham, 2002). Employees need to know how they impact the financial statements because the financial statements are the pulse of the company. If employees are financially illiterate, they may make poor financial decisions because they do not understand how the decisions impact the finances.

The company income statement is a helpful tool for sharing important financial information. Not only does the income statement show employees their role in saving money, but it also can point out areas where employees spend the most money (Stack & Burlingham, 2002). Sharing this information can help cut spending in critical expense areas that impact the bottom line. Another way to further demonstrate employee expenses is by breaking down the cost categories into, for example, fixed labor, variable labor and selling expenses just to name a few. Once employees understand the income statement, they can then better understand its effects on the balance sheet. The balance sheet shows how secure jobs are, how much wealth the company has, and where the company might be vulnerable (Stack & Burlingham, 2002).

Robert Blonchek and Martin O’Neal (1999) list five entrepreneurial beliefs that assist in building an ownership culture: belief in the leader, belief in the purpose, belief in the operating model, belief in empowerment, and belief in the reward.

A high level of trust is built when an organization believes in its leaders. The top characteristics of leaders are honesty, vision, and competence. Trusted leaders make commitments and keep them. They do not say one thing and do another. Trusted leaders follow through with promises they have made, and this builds trust. When employees believe that a leader has the company’s best interest in mind and these interests take precedent over personal goals or agendas, employees can focus on corporate goals, not internal politics (Blonchek & O’Neill, 1999). Employees should be able to question the company’s leaders in an open forum. This will facilitate open communication and build trust. If an organization does not believe in its leaders, and distrust is apparent, employees may look out for their best interests, and not the company’s. Customers will feel this, and in turn, may look for other companies to provide comparable goods or services.

Most employees need to be involved in something with a purpose. When employees share a common purpose, they tend to focus on the big picture. Employee actions align to achieve the purpose and provide personal fulfillment. The purpose of the company needs to be communicated over and over again. Employees cannot lose site of the purpose (Blonchek & O’Neill, 2002). The purpose of a company gives employees a direction and employees can relate what they do to that purpose. At a high level, the purpose is the vision of the company, and employees need a vision of where the company is headed. This helps the employees see the big picture and the end goal of their daily tasks.

In order to build an ownership culture, employees must believe in the operating model. The model includes policies, procedures, processes, and structures of the business. The operating model is how business gets done in an organization, and employees must believe in this. If employees are always passing judgment on how things get done, they will not be effective in their jobs (Blonchek & O’Neill, 1999). The operating model should make getting things done in an organization easier, not harder. Companies should understand this.

Employees must be empowered to make decisions. In a true ownership culture, employees must act like owners and make effective decisions. Employees should be trained on how to make the right decisions. In an ownership culture, employees must believe in the system and in themselves, and employees must know that the organization supports them. Employees must also be allowed to fail and make mistakes. Learning from mistakes proves a valuable lesson (Blonchek & O’Neill, 1999). When effective decisions can be made quickly by anyone in the organization, the organization will thrive. An organization with empowered employees is able to quickly react to many different situations and employees will feel a sense of purpose.

Finally, Blonchek and O’Neil (1999) state that employees must believe in the reward. Employees must really enjoy what they do. When employees believe in the reward, and not only monetary rewards, they believe that they and the company will succeed. When employees act like owners of the business, they protect the bottom line as if it was their own, and they are right.

Stan Vinson, Vice President and Treasurer of CH2M HILL, was tasked with implementing the current employee ownership program at CH2M HILL. CH2M HILL is a private company with over 10,000 employees and is 100% employee owned. Mr. Vinson stated that the most difficult piece of implementing the program is not building the team, coming up with a plan, or designing the technical requirements. The most difficult challenges deal with culture, most importantly, communications. Mr. Vinson went on to describe CH2M HILL’s Shareholder’s Summary Report (SSR), which is published quarterly before the quarterly stock trade. The SSR is a document that disseminates information, communications, and must meet legal requirements. Mr. Vinson described how the SSR must have a proper mix of information, communications, and legal documentation for the employee to get the full message of the company leadership. He went on to state that if the document contained only legal requirements and SEC requirements, it would have limited readership; if the document dealt only with the cultural issues associated with employee ownership and had no substance, it probably would not get read either. The trick is to balance the cultural aspects of employee ownership, with the financial and background information necessary to be an employee investor. Currently the SSR is a product of the business and the regulatory environment, which change from time to time. If the employees do not have trust in their leaders, the SSR means nothing (S. Vinson, personal communication, February 10, 2003).

When asked about building trust in an organization, Mr. Vinson stated that an organization has multiple constituencies, not just one, which most companies and company leaders think is the shareholder. Mr. Vinson explained that the four constituencies consist of the employee, the shareholder, the customer, and the community. He explained that there is a fine balance between these four constituencies. For example, if the customer is treated with a lack of respect, business could be lost, affecting the other three constituencies. Mr. Vinson briefly discussed the Enron and Worldcom fraud issues and suggested that the four constituencies were drastically out of balance. (S. Vinson, personal communication, February 10, 2003). In both cases, the employees were affected by losing their jobs. The community was affected because people could not pay their bills. The shareholders were affected because they lost all their invested money. And lastly, the customer was affected because commitments could not be kept. When a company does not consider the whole environment around them, they may suffer from tunnel vision and focus their efforts in the wrong areas.

Culture is a huge aspect of an employee ownership program, and it must exist or be created for an ownership program to survive. Employees must believe in their leaders, believe in the purpose, believe in the operating model, believe in empowerment, and believe in the reward. When trust is built in an organization, that organization will thrive and employees will make the right decisions for the organization, which in turn are the right decisions for themselves. Communications must also be free between leadership and employees, and vice versa. When a positive corporate culture is created, an employee ownership program will be more likely to succeed.

Liquidity

One problem with a traditional ESOP is, in most cases, employees must retire, terminate, or die to cash in their part of the company. This is the ‘liquidity’ problem. If companies could structure a program that gives the employee the option to cash out their shares at any given point in time, employees might feel a stronger sense of ownership.

Companies can create an internal market to create liquidity. The market matches buyers and sellers of the private stock. If there are more sellers, than buyers, the company could decide to clear the market, or purchase the shares in excess. If there are more buyers than sellers, the company can decide to sell additional shares to employees if desired.

Science Applications International Corporation (SAIC), was founded by Dr. Robert Beyster in 1969 as a scientific consulting firm and now has endeavors in national and homeland security programs, non-nuclear energy studies, health care systems, environment-related businesses, information technologies, high-technology products, telecommunications, transportation and eSolutions services and products for commercial and government customers. Today, SAIC has revenues of $5.9 billion and over 41,000 employees. SAIC was founded on sharing the successes of the company with the people whom created the success. Dr. Beyster is quoted as saying, "Those who really perform well are rewarded by having their stock increased. People involved in the company should share in its success," (SAIC, n.d.).

SAIC has an internal market that provides liquidity for employees. In 1973, Dr. Beyster set up Bull Inc., a registered broker/dealer that would provide a market for employees to buy and sell stock. Stock is traded quarterly and an independent appraiser sets stock price before the trade. Dr. Beyster has never had the goal of taking SAIC public because SAIC does not need the capital and employees already have a way to value their shares (Armstrong, 1999). For a company that wants to remain employee owned, creating an internal market is a good option to creating liquidity for employee shares. Another way to create liquidity is through an initial public offering. When an IPO occurs, liquidity is created for the employees, but control of the company and a stake in ownership is lost. Creating an internal market can be administratively burdensome, involve high cost, and may require regulatory compliance with federal and state securities laws similar of that to being public (FED, 1996). Only companies that have the capital to buy back shares at any point in time should consider implementing an internal market. If cash flow is a problem for the company, it may not want the responsibility of managing buying or selling company shares on a quarterly basis.

Results

Tremendous advantages exist for owners looking to sell their company to an ESOP. Owners who sell part or all of a company can defer capital gains, if after the sale, the ESOP owns greater than 30% of the company, and the seller reinvests the proceeds in stocks or bonds of American companies within one year (FED, 2003). A study has shown that companies realize increases in profits, sales, and stock price after employees become owners, in 75% of the companies studied. Approximately one half of the companies had increased customer satisfaction. Lastly, the study stated that employees produced less when outside investors benefit from their labors (Duncan, 2001).

“A 2000 study by Joseph Blasi and Douglas Kruse at Rutgers University found that ESOP companies grow 2.3% to 2.4% faster than would have been expected without an ESOP for sales, employment, and sales per employee. The study looked at all ESOP plans set up between 1988 and 1994 for which data was available. A 1987 NCEO study of 45 ESOP and 225 non-ESOP companies found that companies that combine employee ownership with a participative management style grow 8% to 11% per year faster than they would otherwise have been expected to grow based on how they had performed before these plans,” (NCEO, 2002).

In the research, it has been stated that a positive culture and participative management style must be created for an employee ownership program to be successful. The study of South Bend Lathe is an example of what can happen to an employee owned company that has a corporate culture that does not allow employees to think and act like owners. A company must focus just as much on creating the culture, as it does on the technical requirements of the ownership program. In creating a positive ownership culture, the company leadership must implement open book management and train employees how to read financial statements, and how their job and actions impacts the financial statements.

Robert Blonchek and Martin O’Neal (1999) list five beliefs that assist in building an ownership culture: belief in the leader, belief in the purpose, belief in the operating model, belief in empowerment, and belief in the reward. When employees believe in the leadership, purpose, operating model, are empowered, and believe in the reward, the employees will begin to act like owners, and take more responsibility in their day to day actions. When employees understand that the company’s best interests are their best interests, employees will be more motivated to perform in alignment with corporate goals.

Discussion/Implications

Project successes

This project identified a problem with employee owned companies. If the proper culture does not exist, the employee ownership endeavor will most likely fail. In the beginning, this project was designed to determine how much employee ownership created the culture, but it was determined that creating an employee owned company did not create the culture. The corporate culture and the actual design of the ownership system should both be considered when designing an ownership program.

When it was determined that the culture problem existed, the project focused on how to create a positive ownership culture where employees would be empowered and act like owners. The project identified some key points on how to create the culture where ownership will thrive.

The research data showed that employee owned companies, in most cases, actually do see increases in return on assets, total shareholder wealth, sales, and profits. Along with the above benefits, owners looking to sell their stake in the business can defer taxes on the sale, if certain requirements are met.

Project failures

This project was unsuccessful in determining the cost of implementing an internal market. Only a few private companies have internal markets; multi-billion dollar companies such as SAIC and CH2M HILL with large ownership budgets. When interviewing Mr. Vinson, he stated that hundreds of companies have shown interest in CH2M HILL’s internal market. When Mr. Vinson explains the overhead and cost involved with implementing and managing the internal market, all the companies say that the cost and effort is too great (S. Vinson, personal communication, February 10, 2003). Even though the cost was estimated to be high, the cost of implementing an internal market could not be identified.

There is no research that compares ESOPs to employee owned companies with an internal market. No research was found to substantiate the need for liquidity. If companies do not have to create liquidity for employees until death, termination, or retirement, but they get increases in performance from a traditional ESOP, would there be any incentive for the employer to create liquidity? The employee might see benefits, but will the company performance increase even more than just having a traditional ESOP?

What could have been done differently?

Instead of focusing on culture in the project design, the project could have focused on how to create an employee owned company, and how to mix various methods to distribute equity. For example, the company could offer a Payroll Stock Deduction Purchase Plan (PDSPP) with a 10% discount, an options program, and a 401k program. The project could have focused on laws and the details of an internal market and discussed which programs and methods of equity distribution work best for short term, mid term, and long-term company goals.

Why did the project turn out the way it did?

The project turned out the way it did partially due to suggestions given to me by the capstone advisor. Originally, the project was going to focus on how to create an employee ownership program using the distribution methods listed earlier in the paper. It was decided that it might be more useful to determine how to create the culture that fosters an ownership environment. There was a common theme throughout the research. Employee ownership programs do not work if they do not have the appropriate culture that empowers employees to act like owners. So, the project focused on this aspect.

The project was a success in finding that the proper culture must be created for an ownership program to be a success. When the culture problem was identified, the project changed course to find a solution to creating the culture that fosters an ownership environment.

Another problem was also identified with ESOPs. In general, employees must terminate, retire, or die to acquire any shares from the ESOP. An employee ownership plan that is focused on liquidity removes this situation. It is difficult to determine the costs of implementing an internal market, and the goals of the company must be in line with creating employee liquidity. The company must have capital to buy back shares if sellers outweigh buyers in an internal market, which could create a cash flow problem for the company.

Issues not addressed and possible effects on the results

This project did not address ESOP or employee owned companies that were acquired or had an initial public offering and how performance varied post-employee ownership. This data was not available, but if it would have been, this might have changed the results of the project. For instance, if it could have been proven that a good method for creating liquidity for employees was through an acquisition or public offering, the approach may have changed. Instead of focusing on how to build an ownership culture, the project may have focused on creating an employee owned company that provides liquidity for employees by going public or being acquired.

How do the results add value to the discipline?

This project has shown the impact of creating a corporate culture that empowers employees to think and act like owners. A lot of the research in this field presents the facts and statistics, and points out that if the culture is not present, the effort will most likely fail. This project provides a good guide on how to create the employee ownership culture, and a company with a culture problem might benefit from this project.

Areas for future investigation

As a separate project, the study of internal markets and creating liquidity for employees should be investigated. It seems logical that employees would like to be able to liquidate their shares of the company if they wished, but this has not been researched. How would this impact company performance for the short, mid and long term? What kind of capital is needed to create an internal market and maintain it? What are the legal requirements? What kind of cash flow is needed to manage an internal market? Have studies been done at CH2M HILL and SAIC on their internal markets in respect to the above questions? If an in an in-depth analysis of internal markets could answer these questions, more companies might invest the capital in an internal market if a return on investment could be determined.

Short, mid, and long term future for the field

ESOPs have an excellent future in the short, mid and long term. Owners should seriously consider selling to an ESOP for succession planning, both for the tax advantages and the performance gains that may be realized. As long as the owner sells greater than 30% to the ESOP, and invests the proceeds in American stocks or bonds, the owner can defer the taxes on the sale. The owner still has a stake in the company, and has created liquidity for him or herself. In this case, the sale to the ESOP creates short-term liquidity for the owner, while creating a long-term investment for the employee.

Conclusion

Louis Kelso created the ESOP under the premise that all employees should share in owning capital-producing assets, not just a few shareholders. In 1974, legislation was passed to give tax benefits to companies that had ESOPs. Owners of companies can sell part or all of the company and defer the capital gains if the ESOP owns at least 30% of the shares and the owner reinvests his or her proceeds in American stocks or bonds within one year.

Research shows that an ESOP or employee ownership program alone will not increase company performance. Employees must feel empowered and act like owners, and when they do, they will respond with increased productivity, greater loyalty, and sustained creativity (Girard, 2002). When the culture and the ownership program are not aligned, the ownership program could fail.

South Bend Late was the first 100% ESOP company funded with capital credit. Union employees in the ESOP were not given voting rights, leading to a labor strike. The unionized employees did not trust management and the labor union refused to negotiate employee ownership issues with the South Bend Lathe. Trust was not built between employees and management, leading to the failure of the ESOP.

Creating the ownership culture needs to be as high of a priority as the technical specifications of the ownership plan. If the proper ownership does not exist, or cannot be created, a company should not think about implementing an ownership program.

 

References

Armstrong, L. (1999, June 21). At SAIC, Owners and workers see eye to eye. How the largest U.S. private info-tech outfit reaps the benefits of employee ownership. Businessweek Online.Retrieved February 16, 2003 from the World Wide Web: http://www.businessweek.com/1999/99_25/b3634026.htm

BenefitsNext (2002). ERISA: An overview. Retrieved January 7, 2003 from the World Wide Web: http://www.benefitsnext.com/content/view.cfm?articles_id=288&subs_id=4

Blonchek, R., & O’Neill, M. (1999). Act like an owner: Building an ownership culture.New York: John Wiley and Sons.

Duncan, J. W. (2001). Stock ownership and work motivation. Organizational Dynamics, 30(1).

ESOP Association. (2003). ESOP facts and figures. Retrieved December 15, 2002 from the World Wide Web: http://www.esopassociation.org/pubs/stats.html

ESOP Association. (2003). What is a leveraged esop. Retrieved January 15, 2003 from the World Wide Web: http://www.esopassociation.org/whatis/leveraged.html

Foundation for Enterprise Development. (1998). The entrepreneurs guide to equity compensation.(2nd. Ed.). San Diego.

Foundation for Enterprise Development. (2003). The non-leveraged leveraged esop. Retrieved January 15, 2003 from the World Wide Web: http://www.fed.org/onlinemag/oct01/tips.htm

Foundation of Enterprise Development. (1996). Providing liquidity for employee shareholders. Retrieved February 16, 2003 from the World Wide Web: http://www.fed.org/onlinemag/april96/2e-providing-liquidity.html

Foundation of Enterprise Development. (2002). Valuation considerations. Retrieved January 9, 2003 from the World Wide Web: http://www.fed.org/resrclib/articles/value.html

Fowler, E., (1997, June 27). Even privately held companies need value established. Austin Business Journal.Retrieved January 9, 2003 from the World Wide Web: http://austin.bizjournals.com/austin/stories/1997/06/30/smallb3.html

Girard, B. (2002, May). Is there an esop in your company’s future? An employee stock ownership plan could enhance your company’s bottom line. Strategic Finance,48-51. Retrieved October 2, 2002 from the World Wide Web: http://www.penlib.du.edu.

Godfrey, J. (2000). Does employee ownership really make a difference? CPA Journal, 70(1).

Ivancic, C. (1999) Sharing the bad news with employee owners. Retrieved Feburary 8, 2003 from the World Wide Web: http://www.nceo.org/columns/bciedu11.html

Kurland, N. G. The South Bend story. What can we learn from an esop failure? Center for Economic and Social Justice.Retrieved Feburary 8, 2003 from the World Wide Web: http://www.cesj.org/vbm/casestudies-vbm/southbendlathe.html

National Center for Employee Ownership. (2002). A comprehensive overview of employee ownership. Retrieved October 25, 2002 from the World Wide Web: http://www.nceo.org/library/overview.html

National Center for Employee Ownership. (2002). A short history of the esop. Retrieved December 31, 2002 from the World Wide Web: http://www.nceo.org/library/history.html

National Center for Employee Ownership. (2002). A statistical profile of employee ownership. Retrieved October 2, 2002 from the World Wide Web: http://www.nceo.org/library/eo_stat.html

National Center for Employee Ownership. (2002). How small is too small for an esop? Retrieved March 1st, 2003 from the World Wide Web: http://www.nceo.org/library/howsmall.html

Rodrick, S. (Eds.). (2000). Selling to an esop: A comprehensive guide for owners, managers, and advisors fo closely held companies.Oakland, CA: National Center for Employee Ownership.

SAIC. About SAIC: Leadership Team. Retrieved Feburary 16, 2003 from the World Wide Web: http://www.saic.com/about/org.html

Stack & Burlingham, J. & Burlingham, B. (2002). A stake in the outcome: Building a culture of ownership for the long-term success of your business.New York: Doubleday.

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